Cooper Industries: Fifth Circuit applies Crime Policy’s Ownership Condition in finding No Coverage for Loss of Funds in Ponzi Scheme

By David S. Wilson and Chris McKibbin

On November 20, 2017, the Fifth Circuit Court of Appeals released its decision in Cooper Industries, Limited v. National Union Fire Insurance Company of Pittsburgh, PA.  The Court applied a crime policy’s ownership condition in ruling that the insured did not have coverage for the loss of funds incurred when an investment entity to which it had provided funds in exchange for promissory notes collapsed due to the entity’s principals’ Ponzi scheme.

The dispute arose out of the same Ponzi scheme that gave rise to the decision of the Eighth Circuit in 3M Company v. National Union Fire Insurance Company of Pittsburgh, PA (see our June 13, 2017 post).  Although there are important factual distinctions between the two losses, the Fifth Circuit reached the same conclusion as the Eighth Circuit in finding that the insured had not demonstrated that it owned the property in issue.

The Facts

Cooper Industries, Ltd. (“Cooper”) was a publicly-traded electrical equipment supplier.  Cooper provided its employees with a pension plan, which was managed by Cooper’s Pension Investment Committee (the “Committee”).  The Committee divided the plan assets into two funds: a bond fund and an equity fund.

In 2004, Cooper began dealing with the principals of WG Trading Company LP (“WGTC”) in respect of investing the benefit plan assets.  The principals of WGTC had another entity, WG Trading Investors, LP (“WGTI”), which was a limited partner in WGTC.  WGTC was a regulated and audited entity, whereas WGTI was not.  The Committee invested approximately $175 million from both its equity and bond funds with the WG entities.  Some of the funds were provided to WGTI in exchange for promissory notes.

Unbeknownst to Cooper, the principals of WGTC and WGTI were running a Ponzi scheme and, over the course of several years, diverted over $130 million from WGTI for their personal use.  The Court noted that, during the course of the fraud, one of the principals spent over $3 million to amass a collection of 1,348 teddy bears, and another $32 million on a hunter pony farm.

In February 2009, the SEC and the CFTC initiated an enforcement action against the WG entities and the principals, and obtained receivership orders.  The receiver had considerable success in recovering assets (including liquidating the teddy bears).  As of the time of the Court’s decision, Cooper had recovered all of its equity fund principal, and all but $1.1 million of its bond fund principal from WGTI.

The Ownership Condition

Cooper claimed under its crime coverage with National Union in respect of the loss.  The policy’s ownership condition provided that:

The property covered under this policy is limited to property:

 (1) That you own or lease; or

 (2) That you hold for others whether or not you are legally liable for the loss of such property.

Before both the District Court and the Fifth Circuit, Cooper maintained that it “owned” the funds in issue, on the basis that it had a beneficial interest in the funds and that the term “own” should encompass both legal and equitable ownership.

Like the District Court before it, the Fifth Circuit rejected Cooper’s contention:

The Policy clearly does not use “own” in such a broad sense.  …  Cooper did not “own” the principal and earnings in the way most people would use that word. It loaned money to WGTI in exchange for promissory notes.  When it made that loan, it gave up possession and control of the funds.  Rather, it “owned” the notes, and the [WG] Entities “owned” the funds.  …  Cooper has cited no case where a Texas court has held that a party continues to “own” funds it was fraudulently induced to loan to someone else.  [emphasis added]

The Fifth Circuit also rejected Cooper’s attempts to rely on case law from other areas to expand the meaning of the term “own” in the policy:

Courts have recognized that “own” can vary with the context.  However, in insurance disputes, courts have generally used the common, everyday definition of the word “own.”  …  Cooper also touts the cases it has identified in a number of other legal contexts — criminal, tax, trust, forfeiture, and takings laws — that recognize that the common meaning of “own” includes equitable ownership.  That entirely misses the point.  Just because courts have interpreted “own” in certain legal contexts to include equitable ownership does not mean that equitable ownership has been imported into the common definition of “own” as a result.  [emphasis added; citations omitted]

The Court also rejected Cooper’s efforts to distinguish the 3M decision:

The Eighth Circuit has likewise held that another victim of Greenwood and Walsh’s fraud did not “own” funds invested through WGTC.  …  Cooper attempts to distinguish 3M because the insured did not argue that “own” included equitable ownership.  We have already rejected that argument and, in doing so, interpret Cooper’s policy not to cover property no longer in the insured’s possession but given over to the [WG] Entities, much as the Eighth Circuit interpreted 3M’s policy.  Adopting Cooper’s position would result in inconsistent interpretations of similar policy provisions — a result we strive to avoid.

As a consequence, Cooper could not establish that it “owned” the funds in issue.

Conclusion

Like 3M and the recent decision of the U.S. District Court for the District of New Jersey in Posco Daewoo (see our November 6, 2017 post), Cooper Industries provides another example of a court applying the ownership condition using the accepted meaning of legal ownership, and rejecting an attempt to unduly broaden the scope of the condition.  While the structure of Cooper’s investments in the WG entities was significantly different from the structure of the investment in issue in 3M, the courts reached the same result.  In each case, the court applied the ownership condition by reference to the concept of legal ownership only, to conclude that neither arrangement satisfied the ownership condition.

Cooper Industries, Limited v. National Union Fire Insurance Company of Pittsburgh, PA, 2017 WL 5562300 (5th Cir.)

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Posco Daewoo: U.S. District Court rejects Creditor’s “Reverse” Social Engineering Fraud Claim under its own Crime Policy

By David S. Wilson and Chris McKibbin

On October 31, 2017, the U.S. District Court for the District of New Jersey released its decision in Posco Daewoo America Corp. v. Allnex USA, Inc. and Travelers Casualty and Surety Company of America. This case features an interesting twist on the usual social engineering fraud claim scenario, in that it was the intended payee of the funds, not the payor, which asserted a claim under its own crime policy for recovery of funds which the payor had been duped into paying to an impostor. This type of claim has been referred to as a “reverse” social engineering fraud claim. Numerous such claims have been advanced by intended payees recently, typically when it comes to light that the payor did not maintain its own social engineering fraud coverage.

The Court applied traditional concepts of ownership in finding that the intended payee did not “own” the funds at any time, and thus could not establish that its claim met the ownership condition in its policy.

The Facts

Posco Daewoo America (“Daewoo”) is an importer and exporter of chemicals. Allnex USA (“Allnex”) is a vendor of specialty chemicals, and was a customer of Daewoo. Daewoo supplied Allnex with product for which Allnex owed payment. In early 2016, an impostor posing as an employee of Daewoo’s accounts receivable department sent emails to an employee of Allnex, requesting that payments to Daewoo on certain outstanding receivables be remitted to “new” Wells Fargo accounts.

Allnex paid $630,058 into the Wells Fargo accounts. By the time that the fraud was discovered, $367,613 had been transferred from the Wells Fargo accounts to accounts overseas. Daewoo never had possession of any of the funds owed to it by Allnex at any time.

The Travelers Coverage

Daewoo maintained a Wrap+ policy with Travelers. Daewoo submitted a claim to Travelers under its Computer Fraud coverage, asserting that the impostor’s emails to Allnex, coupled with Allnex’s transfers to the Wells Fargo accounts, constituted a Computer Fraud loss to Daewoo.

Travelers moved to dismiss the action pursuant to Fed. R. Civ. P. 12(b)(6) for failure to state a claim upon which relief could be granted. While Travelers took the position that the substantive elements of the Computer Fraud coverage had not been established, Travelers also pointed out a more fundamental concern with the claim – Daewoo had not satisfied the ownership condition in the policy. This condition provided as follows:

Ownership of Property; Interests Covered

 The property covered under this Crime Policy … is limited to property:

 i. that the Insured owns or leases;

ii.  that the Insured holds for others:

     (a) on the Insured’s Premises or the Insured’s Financial Institution Premises; or

     (b) while in transit and in the care and custody of a Messenger; or

 iii. for which the Insured is legally liable, except for property located inside the Insured’s Client’s Premises or the Insured’s Client’s Financial Institution Premises.

Travelers took the view that, while Daewoo was undoubtedly owed money by Allnex, Daewoo never actually held the funds, nor had Daewoo been legally liable for them, nor had Daewoo owned the funds.

The Court agreed. In the Court’s view, Daewoo’s failure to meet the ownership condition was dispositive. Until such time as funds were actually transferred to Daewoo, Daewoo had, at most, a receivable and a chose in action (i.e., a right to sue) in the event that it was not paid. This was insufficient for the purposes of the ownership condition:

[Daewoo] has not plausibly pled sufficient facts for the Court to find that it rightfully … possessed or had legal title to the money Allnex transferred into the Wells Fargo accounts. [Daewoo]’s strongest claim to owning that money stems from Allnex’s intention. The parties do not dispute that Allnex intended [Daewoo] to receive the wired money as payment for a debt.   However, a party’s intention of transferring legal title does not equate to an actual transfer of legal title without more. …

 The Court agrees with Travelers that before Daewoo actually received the monies due, Daewoo owned a receivable, or a right to payment, as well as a potential cause of action for payment if it was not made. … In other words, Daewoo did “own” something of value, but it was not the cash in the Wells Fargo accounts. It owned a receivable and a potential cause of action if Allnex did not pay. [emphasis added]

As a result, the Court granted the motion.

Conclusion

Posco Daewoo represents a straightforward application of the ownership condition to a claim that was anything but straightforward. The Court’s analysis reaffirms the fundamental coverage requirement that an insured must own, hold or have antecedent legal liability for the property which forms the subject of a claim.

The Court’s decision provides helpful guidance to fidelity claims professionals in clarifying the distinction between funds which meet the ownership condition, and funds in respect of which the insured has only a right as creditor. The Court effectively rejected the notion that Daewoo’s status as creditor made it a “constructive” owner of the funds in Allnex’s possession. Fidelity insurers occasionally face creative arguments concerning “constructive” ownership, and Posco Daewoo is an example of a court rejecting such arguments.

The decision also reinforces the importance of social engineering fraud coverage – in this case, for companies in the position of Allnex. Although it is not clear from the Court’s reasons, one surmises that Allnex did not maintain social engineering fraud coverage, which might have responded to the loss in issue here. Given the increasing frequency of vendor impersonation and other social engineering fraud losses, insureds would be well-advised to consult with their brokers about the risks that social engineering fraud poses to their business, and the availability of social engineering fraud coverage.

Posco Daewoo America Corp. v. Allnex USA, Inc. and Travelers Casualty and Surety Company of America, 2017 WL 4922014 (D.N.J.)

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Teva: Supreme Court of Canada rejects Fictitious or Non-Existing Payee Defence in finding Collecting Banks Liable for Employee Cheque Fraud

By David S. Wilson and Chris McKibbin

On October 27, 2017 the Supreme Court of Canada released its long-awaited decision in Teva Canada Ltd. v. TD Canada Trust. In a 5:4 decision, the Supreme Court held that two banks that accepted fraudulent cheques procured by a dishonest employee were strictly liable in conversion to the employer, and could not establish the “fictitious or non-existing payee” defence afforded by subsection 20(5) of the Bills of Exchange Act.

The decision is a welcome development for Canadian fidelity insurers who seek to subrogate against banks in respect of certain types of employee cheque frauds. The Supreme Court reversed the decision of the Court of Appeal for Ontario, which had found that the payees were either fictitious or non-existing. The Supreme Court’s decision places fidelity insurers in an excellent position to look to banks as subrogation targets in appropriate circumstances.

The Facts

Teva Canada Limited (“Teva”) is a pharmaceutical company. McConachie was Teva’s Finance Manager. McConachie implemented a fraudulent scheme whereby he prepared false cheque requisition forms for business entities with names that were similar or identical to those of Teva’s real customers. Based on McConachie’s fraudulent forms, Teva’s accounts payable department issued the cheques and mechanically applied the requisite signatures.

The fraudulent cheques were made payable to payees with six different names. Two of those names, PCE Pharmacare and Pharma Team System, resembled the names of existing entities to whom no debt was owed: PCE Management Inc. and Pharma Systems. The four other names (Pharmachoice, London Drugs, Pharma Ed Advantage Inc. and Medical Pharmacies Group) were legitimate entities to whom no debt was owed.

McConachie registered the business names as sole proprietorships and opened bank accounts at several banks, including the Bank of Nova Scotia and TD Canada Trust (the “collecting banks”). He then deposited 63 fraudulent cheques totalling $5,483,249 into these accounts and eventually removed the funds.

After discovering McConachie’s fraud and terminating him, Teva sued the collecting banks in conversion.

The Tort of Conversion and the Bills of Exchange Act

A collecting bank is prima facie liable in conversion where it transfers funds to an improper recipient, unless a statutory defence succeeds. As conversion is a strict liability tort, the bank’s negligence, or lack thereof, is irrelevant; any alleged contributory negligence on the part of the drawer is also irrelevant.

Here, Teva was the drawer of the cheques. The cheques were improperly obtained by McConachie and deposited to accounts held by him with the collecting banks. The collecting banks thereby dealt with the cheques under the direction of one not authorized, and made the proceeds available to someone other than the person rightfully entitled to possession. The collecting banks were therefore strictly liable to Teva in conversion, and would have to compensate Teva unless they could establish a statutory defence.

Before the Supreme Court, the collecting banks relied on the “fictitious payee” defence afforded by subsection 20(5) of the Bills of Exchange Act, which provides that:

Where the payee is a fictitious or non-existing person, the bill may be treated as payable to bearer.

This statutory defence renders a cheque payable to bearer, such that mere delivery, without endorsement, effects negotiation (the cheque would otherwise be payable to order, and would require an endorsement for negotiation).

The issue then became whether the payees were fictitious or non-existing. This analysis involves a two-step framework. The first step, which the majority characterized as the subjective fictitious payee inquiry, asks whether the drawer intended to pay the payee. If the collecting bank demonstrates that the drawer lacked such intent, then the payee is fictitious, the analysis ends and the bank’s defence succeeds. It is crucial to note, however, that “drawer intent” does not mean a specific intention to pay a payee in respect of any particular cheque; rather, the drawer’s intent to pay is presumed, unless the bank demonstrates otherwise.

If the bank does not prove that the drawer lacked such intent, then the payee is not fictitious, and the analysis proceeds to step two. This second step, which the majority characterized as the objective non-existing payee inquiry, asks whether the payee is either (1) a legitimate payee of the drawer; or (2) a payee who could reasonably be mistaken for a legitimate payee of the drawer. If neither of these is satisfied, then the payee does not exist, and the bank’s defence succeeds. If either is satisfied, then the payee exists, and the bank is liable.

The Act does not define the terms fictitious or non-existing, and it has been left to the courts to provide guidance. Canadian courts have generally followed the analytical framework provided by Falconbridge, which the majority quoted in full:

In the case of a bill drawn by [the drawer] upon [the drawee] payable to [the payee], the payee may or may not be fictitious or non-existing according to the circumstances:

 (1) If [the payee] is not the name of any real person known to [the drawer], but is merely that of a creature of the imagination, the payee is non-existing and is probably also fictitious.

 (2) If [the drawer] for some purpose of his own inserts as payee the name of [the payee], a real person who was known to him but whom he knows to be dead, the payee is non-existing, but is not fictitious.

 (3) If [the payee] is the name of a real person known to [the drawer], but [the drawer] names him as payee by way of pretence, not intending that he should receive payment, the payee is fictitious, but is not non-existing.

 (4) If [the payee] is the name of a real person, intended by [the drawer] to receive payment, the payee is neither fictitious nor non-existing, notwithstanding that [the drawer] has been induced to draw the bill by the fraud of some other person who has falsely represented to [the drawer] that there is a transaction in respect of which [the payee] is entitled to the sum mentioned in the bill. [emphasis added]

The Supreme Court’s 1996 Boma decision modified the approach to non-existing payees slightly by finding that the payee was not non-existing in cases where the drawer could reasonably have mistaken a payee for a payee with an established relationship with the drawer. This involves an objective assessment. As a result, according to Boma, a payee will be non-existing when the payee lacks an established relationship with the drawer, unless the drawer could reasonably have mistaken the payee to be one with such a relationship.

Boma’s narrowing of the ambit of non-existing payees becomes extremely significant where the fraudster has, as part of the fraud, caused his employer to issue cheques payable to an entity which has a name similar to, but not the same as, an existing creditor of the employer. It is not uncommon for a fraudster to set up a similarly-named entity to receive cheques, as the similar name deceives the employer and helps to conceal the fraud.

Where there is evidence that objectively establishes such a similarity, the bank’s reliance on the defence can be defeated and the bank will be liable. In Boma, for example, cheques payable to “J. Lam” and “J.R. Lam” were found to be sufficiently similar to the name of a legitimate subcontractor, Van Sang Lam, to allow the Court to conclude that an intention to pay should be attributed. Thus, although “J. Lam” and “J.R. Lam” did not exist in reality, they were nevertheless not “non-existing” for the purposes of subsection 20(5), and the bank was liable.

Here, McConachie used the names of four actual entities that had dealings with Teva, and two entities that did not technically exist, but whose names were similar to entities with which Teva had legitimate dealings.

Applying the principles to the case at bar, the majority held that:

Though only four of the names used were those of existing customers, the other two names used were very similar to names of Teva’s real customers. The motions judge found that there was “a rational basis for concluding that cheques were apparently made payable to existing clients”, and that “the payees could plausibly be understood to be real entities and customers of the plaintiffs”. As a result, the payees were not fictitious or non-existing.

Consequently, the collecting banks were liable to Teva.

Conclusion

Teva is a very significant decision for fidelity subrogation professionals, as fidelity insurers are now better-positioned to look to banks as subrogation targets in certain types of cheque losses. Where a dishonest employee has defrauded his employer through a cheque scam, it is imperative that the fidelity subrogation professional consider potential bank liability. This requires careful analysis, particularly with respect to whether the payee name is “sufficiently similar” to an existing entity with which the insured had legitimate prior dealings. Where the analysis demonstrates that a bank’s reliance on subsection 20(5) of the Act is unfounded, a subrogating fidelity insurer may be able to obtain a significant recovery.

Teva Canada Ltd. v. TD Canada Trust, 2017 SCC 51

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Fidelity Law Association / ABA Fidelity & Surety Law Committee Conference – Boston, November 8-10, 2017

Blaneys partners David Wilson and Chris McKibbin will attend the joint FLA/ABA FSLC Conference. The FLA Conference on November 8 will focus on contemporary fidelity insurance issues, including social engineering fraud claims, knowledge of prior dishonesty, rescission, forensic investigations and communications with claimants and witnesses. The curriculum is designed for fidelity claims professionals, underwriters and lawyers. Chris will moderate the panel entitled The Future Ain’t What It Used To Be: Challenges Facing Fidelity and Commercial Crime Insurers in the 2020s. This panel addresses developing fidelity risks and exposures such as social engineering fraud, ransomware and Bitcoin and other cryptocurrencies.

  • To register, or for more information, click here.
  • A copy of the conference brochure may be accessed here.

The ABA FSLC Fall Meeting on November 9-10 is entitled “Managing and Litigating the Complex Fidelity Claim.” The program is designed as a workshop that will help fidelity claims professionals and lawyers gather useful practical tips to employ in claims handling. The program will feature a number of panel discussions on topics such as effective communications with insureds, discoverability of insurance company documents, ethics considerations, confidentiality agreements and litigation strategies. Chris will participate in the panel entitled Criminal Prosecution of the Accused, which considers how the fidelity claim investigation is affected by parallel criminal investigation and prosecution.

  • To register, or for more information, click here.
  • A copy of the conference brochure may be accessed here.

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American Tooling Center: U.S. District Court finds no Coverage for Social Engineering Fraud Loss under Crime Policy’s Computer Fraud Insuring Agreement

By David S. Wilson, Chris McKibbin and Stuart M. Woody

On August 1, 2017, the U.S. District Court for the Eastern District of Michigan released its decision in American Tooling Center, Inc. v. Travelers Casualty and Surety Company of America. The Court held that a vendor impersonation fraud loss did not fall within the terms of a crime policy’s computer fraud coverage. In coming to this conclusion, the Court found there was no direct causal link between the receipt of fraudulent emails by an insured requesting payment to the fraudster’s bank account, and the insured’s authorized transfer of funds to that bank account.

The Facts

American Tooling Center (“ATC”) is a tool and die manufacturer that outsources some of its work to third-party vendors. One of its legitimate third-party vendors is Shanghai YiFeng Automotive Die Manufacture Co., Ltd. (“YiFeng”). ATC typically sends payment to YiFeng at the completion of various production milestones.

ATC fell victim to a vendor impersonation fraud, which is one of the most common forms of social engineering fraud. On March 18, 2015, ATC’s Vice-President and Treasurer received an email purportedly sent by YiFeng requesting payment to a new bank account. The email in question was sent from the domain name “@yifeng-rnould.com”, which resembled the legitimate domain name “@yifeng-mould.com”. ATC’s Vice-President and Treasurer verified that the applicable production milestones were satisfied, but did not verify the new banking information before wiring approximately $800,000 to the new bank account. When it came to light that YiFeng had never been paid the amounts it was owed, ATC submitted a claim to Travelers.

The Computer Fraud Coverage

ATC’s policy with Travelers provided coverage for:

… the Insured’s direct loss of, or direct loss from damage to, Money, Securities and Other Property directly caused by Computer Fraud.

The Travelers policy defined “Computer Fraud” as:

The use of any computer to fraudulently cause a transfer of Money, Securities or Other Property from inside the Premises or Financial Institution Premises:

1. to a person (other than a Messenger) outside the Premises or Financial Institution Premises; or

2. to a place outside the Premises or Financial Institution Premises.

Travelers took the view that, given the intervening events between the receipt of the fraudulent emails and the authorized transfer of funds, ATC had not suffered a direct loss directly caused by the use of any computer.

The Court agreed, observing that:

the fraudulent emails did not “directly” or immediately cause the transfer of funds from ATC’s bank account. Rather, intervening events between ATC’s receipt of the fraudulent emails and the transfer of funds (ATC verified production milestones, authorized the transfer, and initiated the transfer without verifying bank account information) preclude a finding of “direct” loss “directly caused” by the use of any computer.

The Court relied upon the Fifth Circuit’s recent Apache decision (see our October 24, 2016 post), making specific reference to that court’s observation that:

To interpret the computer-fraud provision as reaching any fraudulent scheme in which an email communication was part of the process would … convert the computer-fraud provision to one for general fraud.

The Court then considered other recent computer fraud decisions, such as Pestmaster (see our August 4, 2016 post) and InComm (see our March 22, 2017 post). Applying the principles from these decisions to the case at bar, the Court concluded:

Although fraudulent emails were used to impersonate a vendor and dupe ATC into making a transfer of funds, such emails do not constitute the “use of any computer to fraudulently cause a transfer.” There was no infiltration or “hacking” of ATC’s computer system. The emails themselves did not directly cause the transfer of funds; rather, ATC authorized the transfer based upon the information received in the emails. The Ninth Circuit [in Pestmaster] has interpreted the phrase “fraudulently cause a transfer” to “require the unauthorized transfer of funds.”[:] “Because computers are used in almost every business transaction, reading this provision to cover all transfers that involve both a computer and fraud at some point in the transaction would convert this Crime Policy into a ‘General Fraud’ Policy.” See also Incomm … (noting that “courts repeatedly have denied coverage under similar computer fraud provisions, except in cases of hacking where a computer is used to cause another computer to make an unauthorized, direct transfer of property or money”). [emphasis added]

The Court granted summary judgment in favour of Travelers.

Conclusion

 American Tooling Center represents another decision in a growing line of jurisprudence which holds that there is no coverage for vendor impersonation and other social engineering fraud losses under traditional commercial crime coverages. The insurance industry has responded by introducing social engineering fraud-specific coverage, which allows insureds to obtain coverage for certain types of losses that fall outside the coverage provided under traditional policy wordings.

Given the increasing frequency of vendor impersonation and other social engineering fraud losses, insureds would be well-advised to consult with their brokers and insurers about the risks that social engineering fraud poses to their business, and the availability of social engineering fraud-specific coverage.

American Tooling Center, Inc. v. Travelers Casualty & Surety Company of America, 2017 WL 3263356 (E.D. Mich.)

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The Brick: Alberta Court of Queen’s Bench finds no Coverage for Social Engineering Fraud Loss under Crime Policy’s Funds Transfer Fraud Insuring Agreement

By David S. Wilson and Chris McKibbin

On July 4, 2017, the Alberta Court of Queen’s Bench released its decision in The Brick Warehouse LP v. Chubb Insurance Company of Canada. The Court found that a vendor impersonation loss did not fall within the terms of a crime policy’s Funds Transfer Fraud coverage. The case represents the first social engineering fraud decision in Canada since the widespread introduction of discrete social engineering fraud coverage, and confirms the principles adopted in several recent American social engineering fraud decisions, including the Ninth Circuit’s decision in Taylor & Lieberman (see our April 3, 2017 post), on which the Court expressly relied.

The Facts

The Brick is a retailer of furniture, appliances and home electronics. In August 2010, an individual called the Brick’s accounts payable department. The caller indicated that he was calling from Toshiba and that he was missing some payment details. He added that he was new to Toshiba. The Brick employee faxed certain payment documentation to a number provided by the caller.

On August 20, 2010, a different individual in the Brick accounts payable department received an email from an individual purporting to be “R. Silbers”, using the email address silbers_toshiba@eml.cc. The individual claimed to be the controller of Toshiba, and indicated that Toshiba had changed banks from the Bank of Montreal (“BMO”) to the Royal Bank of Canada (“RBC”). The email indicated that all payments should be made to the new RBC account, and provided the necessary information to transfer money into the account.

That Brick employee proceeded to change the bank information for Toshiba in the Brick’s payment system to reflect the RBC account information. The employee simply followed the Brick’s standard practice on changing account information. No one from the Brick took any independent steps to verify the change in bank accounts, nor did anyone contact Toshiba.

As a result of the fraud, the Brick directed payment on 10 Toshiba invoices to the RBC account. The real Toshiba eventually followed up on its outstanding receivables, at which point the fraud came to light. The Brick incurred a net loss of $224,475.

The Brick submitted a claim to Chubb under its Funds Transfer Fraud coverage. Chubb denied the claim on March 15, 2012, on the basis that the Brick’s instructions to its own bank had emanated from an authorized employee of the Brick, and that the instructions were not themselves fraudulent. The matter was tried in 2017.

The Funds Transfer Fraud Coverage

The Chubb policy indemnified for “Funds Transfer Fraud by a Third Party”, and defined Funds Transfer Fraud as:

… the fraudulent written, electronic, telegraphic, cable, teletype or telephone instructions issued to a financial institution directing such institution to transfer, pay or deliver money or securities from any account maintained by an insured at such institution without an insured’s knowledge or consent.

The Court interpreted the insuring agreement as requiring that the Brick demonstrate that its bank transferred funds out of the Brick’s account under instructions from a third party impersonating the Brick. Coverage would not be available if the Brick knew about, or consented to, the instructions given to its bank.

The Court then considered how U.S. decisions such as Taylor & Lieberman had addressed this point:

There is no doubt that funds were transferred out of the Brick’s account. The question really is whether the funds were transferred under instructions from an employee who did not know about or consent to the fraudulent transactions.

 In this case, the funds were transferred by a Brick employee as a result of fraudulent emails. [Chubb] seeks to have the court follow [Taylor & Lieberman]. In [that] case, the Ninth Circuit Court of Appeals examined a case with very similar facts. Emails were sent to a company employee who then acted upon them, transferring money out of the insured’s account. The emails were fraudulent. The court held that the insurer was not liable because the Taylor & Lieberman employee requested and knew about the transfers. Although the employee did not know that the email instructions were fraudulent, the employee did know about the transfers. [emphasis added]

The Court further considered the meaning of the terms “knowledge” and “consent” in the definition of Funds Transfer Fraud, noting that:

The Brick contends that the policy provision states that Chubb will pay for direct loss resulting from funds transfer fraud by a third-party, and the focus should be on the fraud itself and not on the fraudulent instructions. While it is true that [the Funds Transfer Fraud insuring agreement] does state that, that clause must be examined in conjunction with the definition of fund transfer fraud contained in the contract. That definition includes the words “insured’s knowledge or consent”. There is no definition in the contract of either the term “knowledge” or “consent”. …

 When a word or a term is undefined, the word should be given its “plain, ordinary and popular” meaning, “such as the average policy holder of ordinary intelligence, as well as the insurer, would attach to it”. One of the definitions of consent is “permission for something to happen, or agreement to do something.” Examining the facts, a Brick employee did give instructions to the bank to transfer funds. The employee was permitting the bank to transfer funds out of the Brick’s account. Consequently, the transfer was done with either the Brick’s knowledge or consent. Even applying the contra proferentem rule, the Brick still consented to the funds transfer. [emphasis added]

The Court concluded by noting that, while the fraudulent emails were undoubtedly the work of a Third Party, the actual transfer instructions were issued by a Brick employee; the transfer itself was not effected by a Third Party. Consequently, the requisite elements of the insuring agreement were not made out.

Conclusion

The Brick provides a Canadian counterpart to recent American social engineering fraud decisions such as Taylor & Lieberman and Apache (see our October 24, 2016 post). The decision covers two points of interest to fidelity claims professionals. First, it confirms that the “fraudulent instructions” to a financial institution contemplated by the Funds Transfer Fraud insuring agreement must be instructions which are themselves fraudulent, rather than authorized instructions issued by the insured which contain mistaken information due to an antecedent fraud. Second (and, effectively, a corollary of the first), it confirms that the instructions to the financial institution must emanate from a third party, rather than from the insured or an employee thereof.

The proliferation of social engineering frauds has created new risks for insureds, and fidelity insurers have responded by creating discrete social engineering fraud coverages. Like its American predecessors, The Brick serves as a reminder to businesses (and to their brokers) of how a business may be exposed to an uninsured loss in the event that it does not maintain such coverage.

The Brick Warehouse LP v. Chubb Insurance Company of Canada, 2017 ABQB 413 [Note: this decision does not appear to be accessible online; please contact us if you would like a copy.]

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3M: Eighth Circuit applies Crime Policy’s Ownership Condition in finding No Coverage for Loss of Undistributed Limited Partnership Earnings in Investment Fraud

By David S. Wilson, John Tomaine and Chris McKibbin

On May 31, 2017, the Eighth Circuit Court of Appeals released its decision in 3M Company v. National Union Fire Insurance Company of Pittsburgh, PA. The Court affirmed the decision of the U.S. District Court for the District of Minnesota (see our October 13, 2015 post), which had applied a crime policy’s ownership condition in ruling that the insured did not have coverage for the loss of investment earnings incurred when an investment entity in which it had a limited partnership interest collapsed due to the entity’s principals’ Ponzi scheme. The Eighth Circuit’s decision provides a good illustration of the interaction between the ownership condition and statutory and common law concepts of “ownership” as they relate to partnerships.

The Facts

In 1999, 3M began investing its employee benefit plan assets in WG Trading Company LP (“WG Trading”). 3M’s investment was structured as a limited partnership in WG Trading. The principals of WG Trading also maintained another entity, WG Trading Investors, LP (“WG Investors”), which was a limited partner in WG Trading. WG Trading was a regulated and audited entity, whereas WG Investors was not.

Unbeknownst to 3M, the principals of WG Trading and WG Investors were running a Ponzi scheme and, over the course of several years, diverted hundreds of millions of dollars from the two entities for their personal use. The SEC and the CFTC initiated civil lawsuits against the WG entities and the principals, and obtained receivership orders. The receiver had considerable success in recovering assets. 3M was able to recover all of the net capital contributions that it had invested in WG Trading.

Nevertheless, 3M took the view that it had still suffered a loss, since at least some of its capital had been invested by WG Trading in legitimate vehicles and had produced legitimate earnings, but 3M was never paid those legitimate earnings. 3M submitted a claim to National Union under its Blanket Crime Policy, and to its excess crime insurers under their follow-form excess policies.

The Ownership Condition

National Union determined that there was no coverage under the policy because, even if the invested funds generated legitimate earnings, the earnings did not fall within the requirements of the ownership condition set out in Endorsement 8 to the policy, which provided, in relevant part, that:

The insured property may be owned by the Insured, or held by the Insured in any capacity whether or not the Insured is legally liable, or may be property as respects which the Insured is legally liable.

National Union took the view that, even if 3M’s investment with WG Trading generated legitimate earnings that could be quantified and attributed to 3M, those earnings were not (i) owned by 3M; (ii) held by 3M in any capacity; nor (iii) property for which 3M was legally liable. 3M argued that the ownership condition did not apply or, in the alternative, that it could be applied in a manner that would bring the claim within coverage.

Before the Eighth Circuit, 3M’s first argument was that the ownership condition did not even apply, as the relevant insuring agreement encompassed “Money, Securities or other property”. 3M asserted that the ownership condition did not apply to coverage for theft of “other” property, because the ownership condition only applied to “insured” property, and the insuring agreement did not specify whose “other” property was covered.

The Eighth Circuit, like the District Court before it, made short work of this argument:

Although the Employee Dishonesty provision does not expressly state whose other property is covered, it is entirely unreasonable to interpret the provision as extending coverage under the Policy to other property that is not insured property. Interpreting the Employee Dishonesty provision as extending to coverage to other property that is not insured property runs afoul of Endorsement 8, which details the property and interests that are covered under the Policy. Thus, when viewed within its context and with common sense, the only reasonable construction of the Employee Dishonesty provision limits coverage under the provision to insured property. Thus, we determine that the ownership requirement of Endorsement 8, which defines insured property, applies to the Employee Dishonesty provision.

3M’s second argument was that, if the ownership condition applied, 3M “owned” the lost earnings because it had a right to possess the earnings and the Court should interpret the condition broadly. The Eighth Circuit rejected this contention as well, essentially adopting the reasoning of the District Court:

However, up until the point at which the earnings were distributed to the partners, the stolen earnings were property of WG Trading — not property of 3M. It is fundamental that property acquired with partnership funds is partnership property, and individual partners do not own partnership assets until the winding up of the partnership.

3M’s final argument was that it met the ownership condition because it had ERISA fiduciary duties relating to the earnings, which rendered 3M “legally liable” for the earnings within the meaning of Endorsement 8. While the District Court did not address the substance of this argument at first instance, the Eighth Circuit considered the argument on the merits and rejected it, holding that:

the ERISA regulation does not alter general commercial property rights, but merely defines the nature and scope of the fiduciary duties owed to plan participants. Thus, this does not affect the ownership nature of WG Trading’s partnership assets. [emphasis added; citations omitted]

As a result, 3M could not bring the lost earnings within the ambit of the ownership condition, and no coverage was available.

Conclusion

The Eighth Circuit’s decision in 3M provides two key findings of assistance to fidelity insurers. First, it rejects the contention that the ownership condition acts as anything other than a pre-condition for recovery under a fidelity policy. Insureds (or their counsel) occasionally contend that there is a dichotomy between an insuring agreement and the ownership condition. The ownership condition, like other conditions in a crime policy, is intended to clarify the coverage provided under insuring agreements. Here, the Court recognized that the ownership condition was to be construed in harmony with, and supportive of, the relevant insuring agreement, and explained why the insured’s attempt to distinguish between “other property” and “insured property” was without merit. A loss must fall within an insuring agreement, and must also meet the ownership condition, in order to trigger coverage.

Second, the Eighth Circuit affirmed the District Court’s analysis of the limited partnership agreements in issue (and its application of state law) in concluding that what 3M actually “owned” was not any of WG Trading’s assets, but rather a limited partnership interest in WG Trading itself, with only the possibility of future receipt of earnings upon distribution.

The same general principles of partnership law apply in Canadian common law jurisdictions such as Ontario. For example, subsection 21(1) of the Ontario Partnerships Act makes it clear that partnership property is legally distinct from property owned by the partners themselves. Thus, it is arguable that a similar result should follow, were such a claim to be litigated north of the border.

[Editors’ Note: Our guest co-author, John Tomaine, is the owner of John J. Tomaine LLC, a fidelity insurance and civil mediation consultancy in New Jersey.  After over thirty-one years with the Chubb Group of Insurance Companies, he retired as a Vice President in 2009.  He is an attorney admitted in Connecticut and New Jersey, and holds a Master’s Degree in Diplomacy and International Relations.  He is available to serve as an expert witness in fidelity claim litigation and to consult on fidelity claim and underwriting matters.]

3M Company v. National Union Fire Insurance Company of Pittsburgh, PA., 2017 WL 2347105 (8th Cir.)

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